Is it better to pay off student loans or credit card debt before you apply for a mortgage?
The answer to your question depends on the interest rate and monthly payments for the student loans and credit cards but it usually makes more sense to pay down credit card debt before you apply for a mortgage.
If you have extra funds and are evaluating what debt to pay down first, focus on paying off the debt with the highest interest rate. This is the debt or loan that is most expensive so paying it down reduces your interest cost the most and saves you the most money. Plus, if you pay off the debt completely you can eliminate that monthly payment from your debt-to-income ratio which increases the mortgage amount you can afford.
For example, if you have a credit card balance with a 15% interest rate as compared to a student loan with a 5% rate, paying off the credit card balance provides a greater financial benefit, even if the loan balance is smaller.
Additionally, paying off the higher cost debt increases your financial flexibility. You can take the money you were spending on your credit card payment and use it to pay down your student loans faster or to save money for the down payment on a home. Either way, you are better positioned when you apply for a mortgage.
Another point to consider is the difference between paying off and paying down a debt and how that impacts your total monthly debt expense. In an ideal scenario, you are able to pay off a debt completely in which case the monthly loan payment is not included in your debt-to-income ratio.
Review What is the Debt-to-Income Ratio for a Mortgage?
In other cases, however, you may only have enough money to pay down a portion of the loan balance. For example, if you have $2,500 in extra funds to pay down debt and a $15,000 student loan and $5,000 credit card balance, how should you use the money?
If you apply the funds to the student loan, you lower the principal balance but your monthly payment remains the same if you have a fixed rate loan. Reducing the principal balance enables you to pay off the loan faster but your debt-to-income ratio does not benefit from a lower monthly student loan payment.
On the other hand, because your monthly credit card payment is calculated based on your outstanding account balance, paying down your balance reduces your required payment. So paying down your credit card balance reduces your interest expense and total monthly debt expense, even if you cannot pay off your entire account balance. The lower your monthly debt payments, the higher the mortgage amount you qualify for.
The example below shows the benefits of paying down your credit card debt before you apply for a mortgage. This example is based on a 30 year fixed rate mortgage with a 4.000% interest rate. The first scenario below shows what size mortgage the applicant can afford before paying down any debt.
Mortgage Qualification Before Paying Down Credit Balance
Monthly Gross Income: $5,000
Monthly Student Loan Payment: $300
Monthly Credit Card Payment: $250
Mortgage Amount Applicant Qualifies For: $325,000
In the second scenario below, the applicant pays down her or his credit card balance which cuts the monthly credit card payment in half. The applicant qualifies for an approximately $345,000Â mortgage as compared to a $325,000 before paying down the credit card. Even though the applicant cannot completely pay off her or his credit card, reducing the account balance increases the mortgage amount the applicant qualifies for.
Mortgage Qualification After Paying Down Credit Balance
Monthly Gross Income: $5,000
Monthly Student Loan Payment: $300
Monthly Credit Card Payment: $125
Mortgage Amount Applicant Qualifies For: $345,000
If you are deciding what debt you should pay down, the best thing to do is evaluate different mortgage qualification scenarios based on different levels of monthly debt expense. Based on this information you can determine how to maximize the mortgage you can afford depending on which loan you pay down and by how much.
Use ourMORTGAGE QUALIFICATION CALCULATORto determine the mortgage you can afford
It is important to highlight that you should always keep a record of any payments you make to pay off or pay down credit cards, student loans or other debts. Cancelled checks, online payment receipts or updated account statements should be sufficient to document the payments.
It can take several months for payment information to be reflected on your credit report so being able to provide documentation to lenders that verifies the payments can be helpful when you apply for a mortgage. You want your debt-to-income ratio to reflect the most updated information about your monthly debt expenses and outstanding loan balances.
Additionally, the sooner you pay off or pay down your debt the better. Paying off a loan completely or closing a credit card account if you have too many open may boost your credit score, but it takes time for your score to reflect these changes. The higher your credit score, the better your loan terms including your mortgage rate and closing costs but if you wait until right before you apply for a mortgage to pay down your debt, you may not benefit from an improved score.
In conclusion, paying off debt can improve your ability to qualify for a mortgage, especially if you pay down high cost credit card balances. Always keep a record of payments that you make and pay down your debt as soon as possible to receive the maximum benefit when you apply for a mortgage.
The table below shows mortgage rates and fees for leading lenders in your area. We always recommend that you shop multiple lenders to find the best mortgage terms. Comparing proposals enables you to find the lender and loan that are right for you.
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Sources
"B3-6-02, Debt-to-Income Ratios." Selling Guide: Fannie Mae Single Family. Fannie Mae, February 5 2020. Web.
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